Monday, August 31, 2015

Non-intuitive Neo-Fisherism

Why is there so little inflation now? How will a rate rise affect inflation? How can we trust models of the latter that are so wrong on the former?

Well, why don't we turn to the most utterly standard model for the answers to this question -- the sticky-price intertemporal substitution model. (It's often called "new-Keynesian" but I'm trying to avoid that word since its operation and predictions turn out to be diametrically opposed to anything "Keyneisan," as we'll see.)

The conventional way of reading this graph is that inflation is unstable, and so needs the Fed to actively adjust rates...When inflation declines a bit, the Fed drives the funds rate down to push inflation back up...When inflation rises a bit, the Fed similarly quickly raises the funds rate.

That view represents the conventional doctrine, that an interest rate peg is unstable, and will lead quickly to either hyperinflation (Milton Friedman's famous 1968 analysis) or to a deflationary "spiral" or "vortex."...

But in 2008, interest rates hit zero...The conventional view predicted that the broom will topple. Traditional Keynesians warned that a deflationary "spiral" or "vortex" would break out. Traditional monetarists looked at QE, and warned hyperinflation would break out...

The amazing thing about the last 7 years in the US and Europe -- and 20 in Japan -- is that nothing happened! After the recession ended, inflation continued its gently downward trend.

This is monetary economics Michelson–Morley moment. We set off what were supposed to be atomic bombs -- reserves rose from $50 billion to $3,000 billion, the crucial stabilizer of interest rate movements was stuck, and nothing happened.

This is a powerful argument, and I think that those who sneer at Neo-Fisherism don't take it seriously enough.

That said, there are some serious caveats. The first is that although the recent American and Japanese experience with QE are powerful pieces of evidence, they are by no means the only pieces of evidence or the only policy experiments. What about the Volcker disinflation, when Fed interest rate hikes were followed by disinflation? I assume there have been at least one or two similar episodes around the world in the last few decades.

Next, are we sure we want to think about interest rate policy as a series of interest rate pegs, each of which people believe will last forever? In the typical New Keynesian model, people believe something much more complicated - they believe that the Fed sets interest rates according to a Taylor-type rule, and monetary policy changes only cause people to change their beliefs when they represent a regime change - i.e. a change in the rule.

But the last reason we should be a little wary of the Neo-Fisherian idea is that it goes against our basic partial-equilibrium Marshallian idea of supply and demand.

Our basic supply-and-demand intuition says that demand curves slope down and supply curves slope up. Dump a lot of a commodity on the market, and its price will fall. Start buying up a commodity, and its price will rise.

Neo-Fisherianism goes against this intuition. Suppose the Fed lowers interest rates. Abstracting from banks, reserves, etc., it does this by printing money and using that money to buy bonds from people in the private sector. That increase in demand for bonds makes the price of bonds go up, and since interest rates are inversely related to bond prices, it makes interest rates go down.

Now, you can write down a model in which this doesn't happen - for example, a model in which Fed money-printing-and-bond-buying stimulates the economy so much that interest rates end up rising instead of falling. But in practice, it looks like the Fed has total control over interest rates (at least, the Federal Funds Rate; let's put aside the question of heterogeneous interest rates).

So when the Fed lowers interest rates, it prints money in order to do so. But in a Neo-Fisherian world, that makes inflation fall - in other words, it makes money more valuable. That's worth repeating: In a Neo-Fisherian world, dumping a ton of new money on the market makes money a more valuable commodity.

That is weird! That totally goes against our Econ 101 intuition! How does dumping money on the market make money more valuable?? Well, it could be one of those weird general equilibrium results, like the "paradox of thrift" or the "paradox of toil". Or it could be because Neo-Fisherians make very strong assumptions about what the fiscal authority does. As Cochrane writes:

One warning. In the above model, the interest rate peg is stable only so long as fiscal policy is solvent. Technically, I assume that fiscal surpluses are enough to pay off government debt at whatever inflation or deflation occurs. Historically, pegs have fallen apart many times, and always when the government did not have the fiscal resources or fiscal desire to support them. The statement "an interest rate peg is stable" needs this huge asterisk.

This makes sense, and it seems like a good reason to wonder if interest rate policy really is best viewed as a series of pegs. If interest rate pegs historically fall apart because the fiscal authority couldn't do its part in maintaining them, it stands to reason that people wouldn't generally expect the current interest rate target to be permanent. Instead, it might be more reasonable for people to expect something more along the lines of a Taylor-type rule, as in the standard New Keynesian model.

Anyway, Neo-Fisherianism continues to be an interesting idea, but I continue to have serious doubts. I want to see international evidence, and evidence with "high" pegs as well as "low" ones, before I believe we've seen a Michelson-Morely moment. I do agree, however, that everyone who still has a standard, Milton Friedman type concept of how monetary policy affects inflation needs to be doing some serious rethinking right now.

Updates

In the comments, Steve Williamson writes:

[I]n the VAR evidence, it can be hard to get rid of the "price puzzle." That was called a puzzle because tight monetary policy led to higher prices. Maybe that's not so puzzling.

Another issue that arose during this period was the “Price Puzzle,” a term coined by Eichenbaum (1992) to describe the common result that a contractionary shock to monetary policy appeared to raise the price level in the short-run...

Christiano, Eichenbaum, and Evans’ 1999 Handbook of Macroeconomics chapter...summarized and explored the implications of many of the 1990 innovations in studying monetary policy shocks. Perhaps the most important message of the chapter was the robustness of the finding that monetary policy shocks, however measured, had significant effects on output. On the other hand, the pesky price puzzle continued to pop up in many specifications.

So the evidence from the 1990s and earlier says that monetary policy works in the classically expected direction (rate hikes lower inflation, rate cuts boost it), but that in the very short term after a policy change, the direction of the effect is often reversed.

But if you look at Cochrane's Neo-Fisherian impulse response graph, that's exactly the opposite of what Ramey talks about:

In this graph, a rate hike is followed first by an indeterminate or perhaps negative jump in inflation, then by a slow convergence in the direction of the interest rate. But Ramey's summary of the evidence is that a rate hike is followed by an indeterminate or perhaps positive jump in inflation (the Price Puzzle), followed by a longer-term downward movement in inflation. In other words, exactly the opposite of the above graph.

So I still think this is a puzzle for Neo-Fisherism.

Steve also has a post responding to mine. Particularly interesting is the argument that Volcker's rate hikes in the early 1980s actually made the inflation situation worse, and that it was his subsequent rate cuts that actually whipped inflation. I'm probably more open to that story than most people, but I think there are a number of things about it that are very fishy, e.g. the fact that inflation started going down after the rate hikes instead of rising further.

Steve also shows a graph that displays a positive correlation between interest rates and inflation. However, this sort of logic leads would also lead us to believe that going to the doctor is the cause of illness, so I would rather trust the VAR evidence that Ramey cites in the chapter Steve linked to. Of course, I don't trust that VAR evidence that much, since it's hard to get credible structural identification on a VAR.

As a final random fun note, the Ramey chapter - which appears on the Hoover Institute's website - contains the following footnote on page 25:

Of course, this view was significantly strengthened by Kydland and Prescott’s (1982) seminal demonstration that business cycles could be explained with technology shocks.

70 comments:

Just because a) interest rates have been at zero and b) we have had very low inflation does not mean that a causes b.

It is so obvious that I don't even know why it needs to be said to people whose job is to know this, that the reason we have low inflation is because private sector debt has stopped rising and government debt is not growing fast enough to keep the demand high enough. When there is low demand there is low inflation.

Private sector debt can not be stimulated even at zero and, short of fiscal loosening (the obviously sensible option) the only way it could be is with some negative interest rate. Which is a stupid idea as well. Just print more money and give it to people who will spend it. That is how you get inflation.

Higher interest rates mean that more money will be diverted from workers (who spend it) to savers (who don't) and will make demand for private sector debt lower - both of these will reduce demand and reduce inflation.

It's really not rocket science Professor Cochrane. And the obfuscating mathematics can not make a ridiculous idea correct.

"Just print more money and give it to people who will spend it."-This is QE."Which is a stupid idea as well"-Why? Works in Denmark. Don't see why fiscal loosening is a sensible option, given that debt is 100% of GDP.

Firstly, QE is not printing money as such. It is swapping one form of money (government debt) for another form of money (USD). And because it is just savings, very little of it is actually spent in the economy. The money spent is from second order effects, like the wealth effect of ramped up asset prices. Therefore it will not be inflationary. If you want to cause inflation (and growth) you need to increase demand - by giving money to people with a high marginal propensity to consume.

Negative interest rates are a stupid idea because it is much easier (if that is your intention) to devalue people's savings by just printing more money.It is far more practiacal and the money printed could be targeted somewhere useful like infrastructure investment. At the moment most investment is in pre-existing assets rather than in GDP-growing investment.

Fiscal loosening is the sensible option because private sector debt is not the way to build an economy and if we have not learnt this by now, I am not sure when we will. I describe the way I see the economy here and in more detail why government deficits are desperately needed:http://www.notesonthenextbust.com/2015/06/the-government-must-run-deficits-even.htmlYou will note that it is based on empirical data.

I see a comment below saying that the mathematics here is correct so it should be taken seriously. This is just ridiculous. 1+1 =2 . This is correct, it doesn't mean we should raise interest rates. If the model is wrong then it doesn't matter how good the mathematics is.

George Cooper describes economics as like pre-Copernican astronomy. I have thought it a little harsh in that, when you see someone like Krugman, he almost has it right. He just ignores the very important aspect of private sector debt. The reason he does this is that when he tries to incorporate Minsky into his models he insists on forcing them into DSGE with loanable funds.

But this here is like a doctor prescribing leeches. I imagine they had very complicated reasons why leeches were good, probably involving phlogiston and bad corpuscles or something. And they used their medical knowhow to convince people it made sense.

But it was complete and utter rubbish and so is this. If we have any empirical evidence from the past 70 years it is that higher interest rates reduce demand and lower interest rates increase demand. The period of 'great moderation' is a testament to this. It completely ignored the build up of private sector debt, but my point is that there is a reason for the Taylor Rule - because it worked to describe interest rate dynamics at above the zero bound.

I have a PhD in maths. I have no problem with maths. But I also build trading models for a living and I know that mathematical elegance is irrelevant. You need something that functions in line with the data. This does not do that. I have tried to build one myself that does. (it is here http://www.notesonthenextbust.com/2015/05/a-major-crash-is-matter-of-time-paradox.html - I use it to describe why I think the economy will crash again soon).

This is ignoring empirical evidence completely to make way for some strange theory. I read this soon after reading this and Roger Farmer's recent call for the US government to print/borrow/ do whatever it takes to support the real economy - oh no sorry, he didn't say to support the real economy, he said to support overvalued shares so that rich people didn't lose money and (because the wealth effect is the most important economic driver) damage the economy. It makes me think that a large part of the economics profession is just there to support the vested interests of those with wealth.

And supporting those with wealth a) damages the economy and b) takes away from those productively working. You can't have an economy where all the money goes to people taking no risk and not producing. Yet this seems to be the way supported by many economists. And they back it up with very precisely computed maths using a totally incorrect model.

I agree with a lot of what you say. Why insist on trying to find the answer with abstraction when you have a lot of evidence out there which you can work with. Most likely there is a complicated story explaining what is going on which will be a mix of supply side and monetary factors that probably covers everything going on now in capitalism from the rise of China to risk aversion by banks in industrialised countries to new lending. There are many pieces to this jigsaw that need to be put together. Just coming up with a fancy mathematical model that supports a ridiculous idea does not clear it up - but greatly distracts us.

re: Ari's comments on private sector debt, I am surprised there's not been more discussion of the possible macroeconomic benefits of easy bankruptcy, both as a way of deleveraging more quickly, and as a way of inhibiting bubbles, by encouraging lenders to pay more attention to whom they're lending to. It seems to me there's been hardly any discussion about repealing the 2005 bankruptcy reform, or the previous reforms which made it harder to discharge student loan debt, or medical debt. It seems to me one overlooked historical advantage of the American economy has been easy bankruptcy, and that suicide rates are linked both to unemployment/discouragement and to harsh bankruptcy laws.

Easier bankruptcy may lead to higher interest rates, but a tradeoff of making debt more expensive in good times but easier to slough off in bad times seems to me beneficial.

I think you've hit the nail on the head Ari. Thank you. As the Fed lower rates private funds left the market, not just because the spread was too low but because inflation is not 0 or negative giving them a Real lack of return of investment. "Private sector debt can not be stimulated even at zero" Zero return is ok if you're the gov't, not if you're a private investor.

"That is how you get inflation."But you don't. History shows to get real inflation you need high(er) rates. The feedback becomes an endless loop. In ZIRP you have attenuation. The money (and wealth) goes to those who get it first, while the rest are left behind. The corporations that benefited from QE benefited from it but did not reinvest into capex and simply built up inventory or stock buybacks. No reinvestment means no growth.

However when you look at inflation itself you see a dichtomy. Prices on most things people use are going up (Food, HC, Education etc). Prices on houses was going down while gas went up. Now it seems reversed. Meanwhile electronics are going down. The one number is not telling the full story.

You are missing the point. No one disagrees with the Volker disinflation. There was no promise to keep rates higher than steady state. During the crisis the Fed adopted language signalling they would keep interest rates at the ZLB for longer than usual. Even as far as at least until a particular date is reached. This remember is exactly Woodford's recommendation. At the ZLB, language and the expectations of future interest rates becomes immensely important and stimulative. It just so happens in our models this mechanism is incredibly (unrealistically) powerful. Keeping interest rates at zero for 6 quarters would cause immensely high inflation today. We saw future markets expecting rates to be that low going forward. It is all about how long interest rates are kept below the steady state. The assumption in the model is with 100% certainty inflation returns to 2%. Volker was putting up with it inorder to transition to a new steady state with lower long run inflation and interest rates.That is one of the keys. Bullard worries that keeping interest rates at the ZLB for so long we may transition to a new steady state of low interest rates and low inflation. Every macro model has inflation and interest rates linked in the long run. Why is it a ridiulous concept that a promise to peg interest rates low forever must deliver low inflation, but 8 years at zero it is there is nothing to worry about.I am not a fan of Cochrane's argument, but it is not fair to say that the neo Fisherian idea is ridiculous. There is clearly something wrong with the basic model as usually formulated. Neo-Fisherian is groping at one possibility.

"No one disagrees with the Volker disinflation." says Charles, but actually, during the Volcker era there were periods* were the Fed raised interest rates and inflation fell, the opposite of the conventional view.

* Now notice that the Fed *lowered* interest rates from 20% to 10% from Feb 1980 to July 1980, and again no effect on inflation EXCEPT at the END of the period, in July, the CPI rate of increase actually *declined*! The *opposite* of the idea of ‘raise Fed rates to lower inflation’! The Fed then again raised interest rates from 10% to 20% from July 1980 until July 1981 but inflation continued during this time at roughly the same reduced pace as from July 1980. In other words, inflation broke on its own without much influence from the Fed, which yo-yo’d around with interest rates, following the market.

didn't understand much of the Cochrane post, but the fact he does not address the downward nominal wage rigidity argument seems to me baffling:

http://krugman.blogs.nytimes.com/2013/04/13/missing-deflation/

In terms of macro policy, FWIW, I think I agree with the helicopter money people. That is, I think there is a difference between increasing reserves and helicopter-money, and that helicopter-money would not have pushed on a string in the way that increased reserves did. http://mainlymacro.blogspot.com/2014/10/helicopter-money.html

"So when the Fed lowers interest rates, it prints money in order to do so. But in a Neo-Fisherian world, that makes inflation fall - in other words, it makes money more valuable. That's worth repeating: In a Neo-Fisherian world, dumping a ton of new money on the market makes money a more valuable commodity."

Cochrane's giving you an example in which there is no money-printing. It's a "cashless" NK model. Of course, you could say that is pretty weird, but that's how NK works. You can do other examples with money in the model, in which money is not neutral - e.g. a segmented markets model. Then, what can happen is that, to make the nominal interest rate go up, you print money at a higher rate. So your premise that the Fed prints money to make the nominal rate go down, need not be correct. There can be a short-run liquidity effect - when the nominal interest rate goes up, the real rate goes up too - but this can be coupled with an increase in inflation, even in the short run.

You're looking for empirical evidence. For example, in the VAR evidence, it can be hard to get rid of the "price puzzle." That was called a puzzle because tight monetary policy led to higher prices. Maybe that's not so puzzling.

"You're looking for empirical evidence. For example, in the VAR evidence,..."

Yeah Noah, you have a hell of nerve expecting Neo-Fisherism theory to give a damn about the rigorous empirical evidence concerning QE. It's a lot easier to display graphs of generally downwards sloping time series and then to exclaim "see!"

I also think Neo-Fisherianism is quite a stretch. However, going through a bit of their mathematics, I had to resign myself that it wasn't all crock. I am not an economist but when skimming the equations I could not find any obvious flaws (although someone better might be able to).

Initially I thought the math was probably good but that causality was used backwards somewhere, then that mathematics was maybe used to give too much importance to corner cases that don't represent the general cases, that the neo-fisherian models overfit unimportant details.

I now lean towards the idea that the model is correct and that it is all about how expectations are used.

Cochrane says it himself: "The difference between traditional Keynesian or Monetarist models and this modern sticky-price model is deep and essential. In this model, people are forward-looking. "

I would say that for Neo-Fisherism to hold people have to be "forward looking" in a special kind of way, probably an unnatural way.

Just the fact that people believe in "Our basic supply-and-demand intuition" and that people believe there is some inertia to prices may sufficiently mold their expectations to make the Neo-Fisherian model invalid.

But there is a greater point to all of this which is that mathematically without considering a certain dose of human psychology in expectations, the value of money through time can almost be seen as indeterminate in some situations. As Cochrane shows, even with rational actors there are multiple equilibria. Relatively pure whims may determine which one we end up in. All we can say is that money ends up being worth whatever others are willing to trade for it. Since it has no intrinsic value there are few other anchors to serve as a benchmark for its value.

I would add that the indeterminacy of the future value of money may get worst when money is held above the amount that can serve as immediate liquidity to perform day to day transactions. The intrinsic value of liquidity can provide somewhat of an anchor for the value of money. However, when money accumulates idly as excess reserves, when it's widely used as a form of savings and replaces other forms of investments then money's value gets away from any natural anchors and human psychology can start to dominate. You can then get neo-fisherian results just by bending expectations a bit in your models. You can model actors to vary spending of their idle cash savings based on their whims and affect money's value counter-intuitively while doing so.

This is yet another reason to keep money always devaluating fast enough that people, businesses and banks don't accumulate too much of it.

"So when the Fed lowers interest rates, it prints money in order to do so. But in a Neo-Fisherian world, that makes inflation fall - in other words, it makes money more valuable. That's worth repeating: In a Neo-Fisherian world, dumping a ton of new money on the market makes money a more valuable commodity."

You really do need to separate out the short-term and long-term effects of the policy experiment. In the long-run, the Fed is actually growing the money supply at a lower rate (and total nominal government debt is also growing at this lower rate). This implication falls right out of the consolidated government budget constraint--something I (along with others) keep stressing--but something everyone seems happy to ignore. I guess I'll just keep trying to remind people that the claims that people make about the conduct of monetary policy depend sensitively on what one assumes about the conduct of fiscal policy.

Yes could you explain this - it looks important - but without "consolidated budget constraint" and other such jargon (or explain what that is). Are you saying that reduced government debt issuance reduces the money supply? Why? Surely the stock of money would only increase if the central bank purchases this debt and issues currency in return. But the central bank is not the only institution purchasing this debt.

As far as I understand this, the money supply in these models is the sum of actual money (without interest) and short term interest bearing government debt (which may thought as reserves). When the central bank raises the interest rate, the government as to pay higher interests, and may issue more debt to pay it. This will increase the "money supply" and increase inflation. So it is not correct to think of monetary policy as substituting money for bonds (as Noah does): what matters is the sum of debt and money and this increases following the rise of the interest rate. But, the government could also increase taxes (or reduce spending) rather tan issue more debt to pay for the higher interests. In the latter case, overall government debt will fall and inflation will fall too. The latter assumption is standard in the Woodford approach to the New Keynesian model, and that's why inflation falls in the standard New Keynesian model.

Noah, I believe the idea is that a monetary injection raises the stock of money (and prices) relative to the future. This implies lower growth in the money stock and lower inflation. In essence, it is like saying that a monetary injection causes a "bubble" in the price of goods and services so their expected return in terms of money is lower.

"So when the Fed lowers interest rates, it prints money in order to do so. But in a Neo-Fisherian world, that makes inflation fall - in other words, it makes money more valuable. That's worth repeating: In a Neo-Fisherian world, dumping a ton of new money on the market makes money a more valuable commodity."

Also, as a technicality, my understanding was that the Fed did change interest rates with open-market operations (buy/sell base money) but that those were more about guiding the market to the new target than affecting the total supply of money. Indeed, demand for base money comes from reserve requirements which are pretty much fixed now. If this is right, there is no relation from a macro point of view between the amount of money and the level of interest rates and we go back to the "cashless model" point that was already made.

This is not true at the 0 lower bound and is also not necessarily true in some essential way but was functionally true as a policy choice. The demand of money is more related to the rate of new money creation caused by the extension of credit. The reserve requirement more forces/allows the fed to gauge monetary policy by creating a market for reserves.

QE-1 was formally adopted in March 2009, when the U.S. T-Bond yield was 2.53%, but by the end of QE-1, in March 2010, the yield had moved up to 3.83%, for a rise of 1.3% points. When the Fed launched QE-2 in November 2010 the T-Bond yield was 2.62%, but 3.16% when QE-2 was ended in June 2011 – a rise of 0.5% points. QE-3 began at the end of 2012, when the T-Bond yield was 1.76%, by the end of QE, it was 2.4%.

“Suppose the Fed lowers interest rates. Abstracting from banks, reserves, etc., it does this by printing money and using that money to buy bonds from people in the private sector. That increase in demand for bonds makes the price of bonds go up, and since interest rates are inversely related to bond prices, it makes interest rates go down.”

I don’t know how you sort out the mess of the bigger debate, but this statement is a fundamental problem.

Abstract all you want, but the fact is that the central bank rate is an institutionally administered rate. It is set. It is not determined by “printing money”.

If the Fed was the only bank, it’s that simple. It sets the rate, just like a commercial bank sets its administered rates.

With commercial banks and a reserve system, it’s a matter of controlling a very small quantity of excess reserves to force banks to compete at that rate (pre-2008), a competition that anchors the reference rate, or simply setting the rate paid on super-excess reserves (2008 +).

You can only abstract so far. Either you have an institution that sets a rate or you don’t.

The thinking that money printing is required to get rates to move in a certain way is fundamentally wrong. You’ll never get to the answer this way because everything that follows that statement must be wrong from the origin on. It’s not the way the world works, however far you abstract it.

The Neo-Fischerite model looks to me like an intellectually bankrupt attempt by economists who want tighter monetary policy whatever the cost to hash together a rationalization, one that if necessary completely obfuscates evidence and theory.

We don't NEED a new theory to explain this "Michelson-Morley" result because it doesn't exist. There are two extremely well defined and not at all obscure supply shocks in the energy sector, the arrival of peak conventional oil contracting supply and the large scale exploitation in shale oil creating a glut, and these explain the inflationary pressure that limited deflation in the immediate fallout of the financial crisis and the deflationary pressure that has prevented accelerating inflation now that the economy is mostly healed.

Likewise, in Japan the deceleration and now basic termination of population growth creates deflationary pressure from the demand side of the equation. Any productivity growth where there is a stable population will cause there to be more goods per currency unit, all other things being equal.

Other factors in Japan can also be highlighted to explain the low interest rate disinflationary/deflationary behaviour. The Japanese banks were debt constrained following the collapse of the late 1980s Japanese property boom and Japan having become a relatively high cost economy saw Japanese business redirect investment to China. These demand and supply side pressures kept the Japanese economy relatively quiescent.

Seems like Cochrane ignores fiscal policy. The Republican Congress hit the economy with unprecedented austerity. The defcit went from 10 percent to 2.3 percent. Bernanke and the Fed complained regularly about fiscal headwinds. It's no wonder the Fed never managed to hit their 2 percent inflation target ceiling, given that all they tried was a few weak QEs.

Whenever inflation expections dipped, they did a QE, and they went back up. That's it. They weren't trying to raise inflation quickly. They are paranoid about inflation getting out of hand and becoming "unmoored."

"What about the Volcker disinflation, when Fed interest rate hikes were followed by disinflation? I assume there have been at least one or two similar episodes around the world in the last few decades."

The ECB raised rates in 2011 and got disinflation. There are many examples.

"In the above model, the interest rate peg is stable only so long as fiscal policy is solvent. Technically, I assume that fiscal surpluses are enough to pay off government debt at whatever inflation or deflation occurs."

Cochrane seems to be saying that fiscal policy is only solvent if over the long run the budget is balanced and the debt is paid off. However, perpetual deficits are sustainable if the interest paid on the debt is lower than the growth rate of the economy. In other words there's no need for the budget to be balanced and the debt paid off in order for fiscal policy to be solvent.

Oh, Noah. What you've got here is manipulative pseudo-scientific nonsense on a par with creation science. Stop giving it credibility.

Cochrane: "How will a rate rise affect inflation? ... Well, why don't we turn to the most utterly standard model for the answers to this question -- the sticky-price intertemporal substitution model. ... According to this standard model, the answer is clear: Inflation rises throughout the episode, smoothly joining the higher nominal interest rate."

That's because the model is built on the Fisher equation, which assumes lenders adjust interest rates to inflation rates. The model matches data because lenders do that. It predicts a rate rise would be accompanied by rising inflation because it assumes the central bank wouldn't increases rates unless inflation were rising. It does not predict what would happen if a central bank went bonkers and started adjusting rates in the opposite direction from inflation.

Cochrane: "the conventional doctrine [is] that an interest rate peg is unstable, and will lead quickly to either hyperinflation ... or to a deflationary spiral or vortex."

The conventional doctrine is that an interest rate peg *that's very far from the equilibrium real interest rate* would lead quickly to hyperinflation or a deflationary vortex.

Cochrane: "We set off what were supposed to be atomic bombs -- reserves rose from $50 billion to $3,000 billion, the crucial stabilizer of interest rate movements was stuck, and nothing happened."

Noah: "This is a powerful argument, and I think that those who sneer at Neo-Fisherism don't take it seriously enough."

This is a total balderdash argument, and it deserves every sneer it gets. Reserves rose when risks were perceived to be on the side of deflation, and by rising demonstrated that the zero bound was not the limit of monetary policy. Those who said they saw an atomic bomb mostly acted as if they themselves didn't believe it.

Noah: "What about the Volcker disinflation, when Fed interest rate hikes were followed by disinflation? I assume there have been at least one or two similar episodes around the world in the last few decades."

Actually hundreds or thousands, depending on how strict you set your criteria. The response of inflation to tightening and loosening is not controversial. In the most liquid markets the initial adjustments in response to off-expectation monetary policy announcements to asset prices sensitive to inflation expectations are made by pre-programmed trader-bots. If Cochrane thinks they’re all wrong, he should try to launch a fund that exploits that.

Noah: "In a Neo-Fisherian world, dumping a ton of new money on the market makes money a more valuable commodity. That is weird! That totally goes against our Econ 101 intuition!"

1. You shouldn't be comparing Ramey's VAR results with Cochrane's impulse responses, as it's a different experiment. Ramey is a one-time random shock - say, interest rate goes up and back down, if you buy the identification.

2. "I don't trust that VAR evidence that much, since it's hard to get credible structural identification on a VAR." I don't trust it much either, but a lot of people take it seriously, apparently.

1. I figure Ramey's paper tells you all you need to know about that stuff. She's supposed to be capturing the state of the art in the VAR literature for the Handbook. Like you, I don't take the whole methodology very seriously, so it's not really worth trying to figure out how this NK model might match some VAR impulse responses. I shouldn't have even brought it up.

2. We have models. We have data. You give the RBC guys a hard time, but they had a methodology, some notion of what they wanted to explain, and an idea about what success in explaining the data might be. NK models of the type that Cochrane is playing with have been fit to the data. Typically, researchers use Bayesian methods, and they do that for a reason, as maximum likelihood would give parameter estimates that they would not like - e.g. the Phillips curve might slope the wrong way, or some such. Priors matter in a big way. That doesn't stop anyone from using these things though, even though they don't fit the data. I could start sounding like you after a while - macro is bunk, etc.

Please correct me if I'm wrong, but this is what I don't get about Neo-Fisherianism: whatever the mathematical merits of the N-F view (which I'm not qualified to discuss, I'm just a blog-reading engineer), actors in rational expectations models have the same model of the economy as, well, the model (right?). For them to kind-of describe reality, people have to kind-of think that the economy works more or less like that. How the fuck, then, can an N-F results be practically relevant at all in a reality when that view is believed by just a bunch of academics? How can it be an accurate description of a world where the actors have the opposite expectations about monetary policy? If the N-F conclusions are unavoidable within the framework of modern macro and we have to discard the standard view, we should probably discard the whole thing as well because there is no sane way to reconcile it with reality.

"So when the Fed lowers interest rates, it prints money in order to do so. But in a Neo-Fisherian world, that makes inflation fall - in other words, it makes money more valuable. That's worth repeating: In a Neo-Fisherian world, dumping a ton of new money on the market makes money a more valuable commodity."

Noah, the reverse claim would not make sense either. If the FED printed money to lower interest rates, and printing money led to inflation making money less valuable, then shouldn't interest rates rise?

For instance, if Zimbabwe central bank printed money to buy govt bonds, inflation would go through the roof, so would the interest rates on those bonds making them worthless.

Why does printing money lead to low interest rates in the US, but high interest rates everywhere else? There is gotta be something else going on (expectations about the future increases in money supply, liquidity demand, etc.) that needs to be explained.

"For instance, if Zimbabwe central bank printed money to buy govt bonds, inflation would go through the roof, so would the interest rates on those bonds making them worthless."

That's what the FED usually does (except unconventional monetary policy). It prints money to buy government bonds. It's conventional monetary policy: you change the composition of the liabilities of the government (total debt = money + bonds).

Dan, this is a short rates vs long rates issue. Increasing the supply of money is a factor pushing down short rates by increasing the supply of money relative to demand to borrow it. But loosening also increases output and inflation expectations, which is a factor pushing up long rates.

Hyperinflation is actually a fiscal phenomenon: a government with a captive monetary authority prints money and spends it. This might involve a nominal issuance of bonds and swap of them to the monetary authority at some notional interest rate, but there is no sovereign bond market interest rate in a hyperinflating economy.

M., most QE is not really a swap of assets with the private sector: it's just monetary financing (the central bank prints money, the government prints bonds and swaps them for money, the government spends money). The sovereign bond supply in private hands is not reduced unless the volume of central bank bond purchases exceeds net issuance by the government, which never happened in the US.

The reason why printing money had such different effects in the US and Zimbabwe has to do with the mild and later zero fiscal expansion in one and the hyperexpansion in the other, the huge difference in scale of money printing relative to GDP, and the huge difference in people's willingness to hold the currency or bank deposits as savings.

"Dan, this is a short rates vs long rates issue. Increasing the supply of money is a factor pushing down short rates by increasing the supply of money relative to demand to borrow it. But loosening also increases output and inflation expectations, which is a factor pushing up long rates."

I still don't understand. Will increasing the money supply increase prices? That's the part Noah finds counter-intuitive. If you agree, then why are short-rates declining with increasing inflation?

I suppose if the fed actions fix some inefficiency increasing output, that'd make future inflation higher which would increase long-term rates even more. But the short rates would still increase and the difference between short and long rates would depend on market frictions and investors ability to move consumption/investment over time (e.g. if you expect prices to increase you may want to buy stuff now, increasing prices today).

I think you just misread Noah. He wrote that the proposition that printing money causes disinflation is counterintuitive. And of course it's not merely counterintuitive, it's goofball.

Yes, increasing the money supply is a factor pushing up inflation. The only caveat is that it functions at least mainly by pushing down short rates, which is ineffective if already at the ZLB.

The easiest way to test this is by looking at how prices of assets sensitive to inflation expectations react to unexpected loosening announcements. They adjust their expectations hotter, as a rule. That's one of the first things that gets automated (I'm talking about computers that read monetary policy announcements and move various prices in response, which in big markets happens incredibly quickly these days.) Granted, there's always some battle between the hotter push of the loosening and the signal that the economy has been cooling given by the central bank's unexpected decision to loosen. But as a rule, markets give greater weight to the former, at least in their first reaction.

It seems most of the commenters trying to defend Cochrane are basically cheating, by introducing other complicating factors he didn't consider that according to the commenters might make Cochrane's nonsense become true.

Arguments about the transmission mechanism from central bank rates to market rates, or to term spreads, or to fiscal policy, all may be worth looking at. Arguments about longer-run effects (eg tightening too much will damage potential and be followed by loosening and higher inflation) might be worth looking at. But they have nothing to do with Cochrane's argument. The model he uses has one single interest rate that stands in for the entire complex of central bank and market interest rates. Notice that he doesn't even try to explain why the model produces the result he says or relate any of its workings to anything real. He just plugs in some unusual inputs into a very limited-purpose model and says, look, unexpected results!

"Will we get inflation? The scenario leading to inflation starts with poor growth, possibly reinforced by to larger government distortions, higher tax rates, and policy uncertainty. Lower growth is the single most important negative influence on the Federal budget. Then, the government may have to make good on its many credit guarantees. A wave of sovereign (Greece), semi-sovereign (California) and private (pension funds, mortgages) bailouts may pave the way. A failure to resolve entitlement programs that everyone sees lead to unsustainable deficits will not help. When investors see that path coming, they will quite suddenly try to sell government debt and dollar-denominated debt. We will see a rise in interest rates, reflecting expected inflation and a higher risk premium for U.S. government debt. The higher risk premium will exacerbate the inflationary decline in demand for U.S. debt. A substantial inflation will follow—and likely a ‘‘stagflation’’ not inflation associated with a boom. The interest rate rise and inflation can come long before the worst of the deficits and any monetization materialize. As with all forward-looking economics, no obvious piece of news will trigger these events. Officials may rail at ‘‘markets’’ and ‘‘speculators’’. Economists and the Fed may scratch their heads at the sudden ‘‘loss of anchoring’’ or ‘‘Phillips curve shift’’. This is a scenario, not a forecast. Whether it happens depends on the actions of our public officials, which are very hard to forecast."http://faculty.chicagobooth.edu/john.cochrane/research/papers/understanding_policy_EER.pdf

"Will we get inflation? The scenario leading to inflation starts with poor growth, possibly reinforced by to larger government distortions, higher tax rates, and policy uncertainty. Lower growth is the single most important negative influence on the Federal budget. Then, the government may have to make good on its many credit guarantees. A wave of sovereign (Greece), semi-sovereign (California) and private (pension funds, mortgages) bailouts may pave the way. A failure to resolve entitlement programs that everyone sees lead to unsustainable deficits will not help. When investors see that path coming, they will quite suddenly try to sell government debt and dollar-denominated debt. We will see a rise in interest rates, reflecting expected inflation and a higher risk premium for U.S. government debt. The higher risk premium will exacerbate the inflationary decline in demand for U.S. debt. A substantial inflation will follow—and likely a ‘‘stagflation’’ not inflation associated with a boom. The interest rate rise and inflation can come long before the worst of the deficits and any monetization materialize. As with all forward-looking economics, no obvious piece of news will trigger these events. Officials may rail at ‘‘markets’’ and ‘‘speculators’’. Economists and the Fed may scratch their heads at the sudden ‘‘loss of anchoring’’ or ‘‘Phillips curve shift’’. This is a scenario, not a forecast. Whether it happens depends on the actions of our public officials, which are very hard to forecast."http://faculty.chicagobooth.edu/john.cochrane/research/papers/understanding_policy_EER.pdf

I'm a little frustrated about the meaning of ''short term" or "long term" or "very short term" in economics. Compared to physics, economics is stuck in the phase between the (mythological?) apple falling on Newton's head and him discovering the formula of gravitation. It would be useful to determine, exactly when New Keynesian mechanics are trumped by the Neo-Fisherian relation.Or the price puzzle: anyone watching the daily stock market regularly knows that sometimes expectations of central bank decisions are guessed somewhat incorrectly, so basically, stock prices do not in relation to interest rate changes but to the deviation from market expectations. Does this behavior fall under "very short term"?It's hard to pin down the precise relationships if economic models continue to use the "t+n" system.

Neo-Fisherians are trying to build an argument based on an ex-post identity without proper identification of causality! That's never a good idea! The most amazing thing is that not once have I heard the mention of Money Demand, which of course is the key to this puzzle! First, let me address the NF claim regarding the real rate of interest. There is no evidence/theory as to why the real rate of interest should trend toward some long-term value that is exogenous to the economy, say 2%. People are willing to pay interest in order to borrow because they expect their incomes to grow in the future. Accordingly, the source of interest is income growth, and growth expectations determine interest rates (assuming the central bank supplies base money consistent with private agents' preferred allocation of their long-term savings between money and financial assets). In the aftermath of the Great Recessions, income growth expectations took a tumble. Furthermore, expectations are being further depressed by the burden of private debt, which agents no longer view as sustainable in the absence of housing appreciation. In other words, we have been operating in a world of depressed and even negative expectations.

More importantly, money demand is inversely related to income expectations as agents with negative or stagnant income expectations attempt to hold their long-term savings in the form of money as opposed to financial assets. Since the Great Recession, money demand has risen dramatically to basically offset the monetary base expansion by the Fed. What this means is that monetary policy has been largely neutral despite 0% interest rates and three rounds of QE, which explains why inflation pressures have been so low!Second, let me address the velocity of money. Velocity is the most misunderstood macro-variable. It has nothing to do with the speed at which money circulates in the economy. As money is a liability that can be created and redeemed in the same period, such “speed of circulation” could be infinite. Nor is velocity an ex-post residual as in QP=MV. Rather, velocity is a measure of ex-ante money demand. The causality in QP=MV flows from MV with prices and employment being residuals (as the supply curve is fixed ex-ante by the available capital and technology, firms can respond to ex-ante change in aggregate demand(MV) only by changing prices (P) and employment (Q=K(E)) in the current period). With such understanding of velocity, a resort to Neo-Fisherian ideas is unnecessary and misguided (nor is there a need for price/wage stickiness to explain biz cycle – but that’s a different conversation).

Volcker's rate hikes in the early 1980s actually made the inflation situation worse, and that it was his subsequent rate cuts that actually whipped inflation.

Only someone who had no clue what happened in the early eighties could think that. I spent the early eighties foreclosing on people who could not afford Volcker's interest rates (and losing half the value of my house).

A a general proposition, I think that neo-Fisherism is nonsense but one could probably write down a model where the middle class is trying to smooth out consumption over their life time and then if you drop the interest rates, savings go up and spending goes down for those people who are still working, putting downward pressure on prices.